Feet of Clay

by George Selgin January 28th, 2014 6:40 pm

I never thought it would happen--perhaps I'm slipping.  But as I was preparing to bang-out this post, my first in over a month here, I discovered that, a couple hours ago while I was toiling away in class, Paul Krugman stole my thunder.

Despite that bad omen, I'm plunging in with my two-cents, which, like Krugman's, has been provoked by an article in today's New York Times.  The article, which is mainly about Minneapolis Fed President Narayana Kocherlakota, who just recently rotated onto the FOMC, includes a quote from Ed Prescott, who is himself (among other things) a member of the Minneapolis Fed's research staff.  What Prescott said--and what put Krugman in high dudgeon--is: "It is an established scientific fact that monetary policy has had virtually no effect on output and employment in the U.S. since the formation of the Fed."

That's right: no effect--none, nada, zero, zilch--on output, or on employment, ever.  Not even in the 30s.  Or in the 70s.  Or recently.  Why, the Fed might as well set its policy targets by throwing darts at a board, for all the difference it would make to real activity.  Money's just a veil, after all.  We know that--what's more we know it "scientifically."

Krugman rightfully pours scorn on Prescott's assertion, which states a "scientific fact" only in the peculiar sense that distinguishes such facts from ordinary, unqualified, plain-old facts, that is, the sort of facts one might glean from experience.   A "scientific fact," apparently, is not such a grubby affair.  It is, rather, something much more pure, even virginal; it is a fact implied by a theory.  The theory in this case is of course the "real business cycle" theory for which Prescott (and coauthor Finn Kydland) are famous.  The theory starts with the New Classical premise that prices always adjust instantly to their general equilibrium levels, thereby all but eliminating any scope for real consequences of monetary disturbances.  It then proceeds--hey presto!--to the conclusion that, if real variables bounce around, they must do so in response not to monetary but to real shocks.   It follows, as a matter of logic, that the world economy must have met with a whale of an adverse supply shock in the 1930s.  What shock, you wonder?  What difference do such details make?  There had to be a big bad shock, dontchyasee: the theory proves it.   If the historians and econometricians can't find it, well, so much the worse for history and econometrics.

Some Austrian economists like to insist on the a-priori nature of their discipline, while many non-Austrians, myself among them, fault this sort of Austrian economics for its failure to to be swayed by experience.   But when it comes to dogmatic a-priorism,  even the most doctrinaire praxeologist can't hold a candle to some of the economics profession's perfectly mainstream superstars.


Warren Coats on Bitcoin

by Kurt Schuler January 26th, 2014 11:41 pm

Worth your while to read. Warren, as some readers will know, has a wide range of experience with monetary policy and successful monetary reform over time and around the world.


Reserve requirements and free banking

by Kurt Schuler January 20th, 2014 1:00 am

“The Banks are required to have reserve of specie equal to one-third of the amount of Bank Notes in circulation. The declared average Monthly Circulation of Notes by the Banks has been about £285,459; and the Treasurer [the government official in charge of bank regulation] has always found the reserve considerably to exceed the required one-third.” (Ceylon Blue Book for the Year 1870, page 485. Colombo: William Skeen, Government Printer, Ceylon)

The passage above points to three aspects of free banking regulation. One is that reserve requirements existed.

The second is that they were not necessarily binding. That banks' actual reserves always considerably exceeded their minimum legally required reserves suggests that at the time, the note-issuing banks in Ceylon (today Sri Lanka) would have held the reserves even without any legal requirement, purely out of business considerations.

The third aspect is that, though not binding in 1870, the requirement could have become binding later. The spread of the telegraph and of new techniques of financial management across branch networks connected by quick communication were among the factors that led to a general decline in bank reserve ratios during the late 19th century.

Free banking is a system of competitive issue of money and credit. The more competitive it is the freer it is. Trying to decide in particular cases when a banking system was nearer or farther from the fully competitive pole involves knowing about the historical details. In one of my first papers on free banking, a survey of all the then known episodes (in The Experience of Free Banking, edited by Kevin Dowd; not legally available online), I summarized the major regulations I knew of for each episode. Ignacio Briones (who wrote a dissertation in French about Chile's free banking period) and Hugh Rockoff (whose re-examination of U.S. so-called "free banking" influenced those of us who have written about the more truly free banking that existed in other countries) wrote a worthwhile article almost a decade ago with a taxonomy of regulations and their effect on bank freedom. It would in principle be possible to devise an index of bank freedom based on their taxonomy or another one. Currently we are still far from the level of detail we need to know to make such precise, or apparently precise, comparisons across many countries.


The Bullionist debates (guest post by Mike Sproul)

by Kurt Schuler January 11th, 2014 5:39 pm

(Here is another guest post by Mike Sproul. I will finally write my second reply to Mike on the "backing theory" by next weekend.)

On February 26, 1797, the Bank of England suspended convertibility of the pound into gold. Up until then, anyone who held a deposit at the Bank of England, or a paper pound issued by the Bank of England, had been able to redeem a pound at the Bank for just over ¼ oz. of gold. But a run had reduced the Bank’s gold reserves to 1/7 of their former level, and if not for the suspension, the Bank’s gold reserves would have been gone in a few more days.

The effects of the suspension were surprisingly positive. Business revived, and the pound initially held its value. But from 1797 to 1810, the pound fell by 20% against gold. The depreciation of the pound ignited what became known as the Bullionist debates. On the Bullionist (Quantity Theory) side, David Ricardo blamed the Bank of England for issuing more paper money than the economy could absorb.

"The issues of paper not convertible are guided by the same principle, and will be attended with the same effects as if the Bank were the proprietor of the mine, and issued nothing but gold. However much gold may be increased, borrowers will in- crease to the same amount, in consequence of its depreciation and the same rule is equally true with respect to paper. If money be but depreciated sufficiently, there is no amount which may not be absorbed, and it would not make the slightest difference whether the Bank with their notes actually purchased the commodities themselves, or whether they discounted the bills of those who would so employ them." (Ricardo, 1810, p. 85)

On the Antibullionist (Real Bills) side, Charles Bosanquet denied that the Bank of England had caused the inflation.

"...(inflation will result whether) the issue be gold from a mine or paper from a government bank. All this I distinctly admit, but in all this statement, there is not a single point of analogy to the issues of the Bank of England."

The principle on which the Bank issues its notes is that of loan. Every note is issued at the requisition of some party, who becomes indebted to the Bank for its amount, and gives security to return this note, or another of equal value... (Bosanquet, 1810, p. 83.)

Economic historians have been very kind to Ricardo, and his Reply to Mr. Bosanquet has been described as “perhaps the best controversial essay that has ever appeared on any disputed question of Political Economy.” (McCulloch, John R., 1845). In contrast, “poor Bosanquet is left cutting a very sorry figure.” (Sayers, R.S., 1953).

The Bullionist debates provide an excellent example of what happens to a debate when both sides are making fundamental errors. Both Ricardo and Bosanquet failed to understand the differences between gold, government-issued paper money, and privately-issued paper money (bank notes). Ricardo could not see that gold produced from a mine was an asset to its producer, while paper money is a liability to its issuer. The discovery of 1 oz. of gold would raise the discoverer’s net worth by 1 oz, while the issuance of paper money would not affect the issuer’s net worth. Ricardo never understood that since paper money is normally issued in exchange for equal-valued assets, the assets of the issuer naturally keep pace with the quantity of paper money it has issued.

Bosanquet made the same mistake when he equated gold with “paper from a government bank”. Having seen the inflation of the Continental dollars in America, and Assignats in France, Bosanquet concluded that the issuance of government paper money was fundamentally the same as digging new gold from the ground. Bosanquet and Ricardo both failed to see that government-issued paper money, such as the Continentals and the Assignats, was the liability of the government that issued it, and was backed by the assets of that government. Only when the quantity of government paper money outran the government’s assets would inflation result.

Bosanquet correctly saw that bank notes were issued on loan, were the liability of the issuing bank, and thus were fundamentally different from gold. He failed to see that Assignats and Continentals were also issued on loan, were the liabilities of the issuing governments, and were fundamentally the same as bank notes (and different from gold). This put Bosanquet in an inconsistent position: If money that is “issued on loan” is not subject to inflation, then why did the Assignats and Continentals inflate? If money issued on loan does cause inflation, then he would be forced to admit his opponents’ contention that the Bank of England had caused inflation. This was a weakness that Ricardo was quick to exploit.

"Let us suppose all the countries of Europe to carry on their circulation by means of the precious metals, and that each were at the same moment to establish a Bank on the same principles as the Bank of England — Could they, or could they not, each add to the metallic circulation a certain portion of paper? and could or could they not permanently maintain that paper in circulation? If they could, the question is at an end, an addition might then be made to a circulation already sufficient, without occasioning the notes to return to the Bank in payment of bills due. If it is said they could not, then I appeal to experience, and ask for some explanation of the manner in which Bank notes were originally called into existence, and how they are permanently kept in circulation. (Ricardo, 1810, p. 87.)"

Ricardo failed to see any difference between gold and bank notes. He did not mention that adding a “certain portion of paper” to the circulation might cause an offsetting amount of coins or other moneys to be removed from circulation.  He never considered that inflation could have been caused by a drop in the value of the Bank of England’s assets, and so when confronted with the fact of 20% inflation, he considered it proof that the Bank of England must have over-issued its money. By his logic, the mere existence of bank notes proved that they were over-issued.

So on the Bullionist side we have Ricardo, who wrongly lumped both bank notes and “government paper” together with gold. On the Antibullionist side we have Bosanquet, who correctly saw the difference between bank notes and gold, but still made the mistake of lumping government paper together with gold, rather than with bank notes. Neither side considered the Backing Theory. If they had, they might have seen that bank notes and government paper are both liabilities of their issuers, and are both valued according to their issuer’s assets. Thus, the 20% fall in the value of the paper pound could be attributed to a fall in the Bank of England’s ratio of assets to liabilities.

Since no one considered the Backing Theory, observers of the debate were left to choose between two flawed theories. Bosanquet’s errors were the more obvious of the two, since his assertion that issuing Bank of England notes on loan could not cause inflation left him unable to give a convincing explanation for the 20% inflation that had taken place.  Ricardo’s Bullionist theory, despite its flaws, at least yielded the simple (though misleading) result that inflation was caused by an increase in the quantity of money.

The victory of Ricardian Bullionism has left monetary theory in an unsettled state ever since.  The same mistaken ideas about the inflationary effects of gold, of government paper, and of bank notes, were a central part of the Currency School/Banking School debates of the 1840’s, the “Qualitative Credit Control” debates of the early twentieth century, James Tobin’s New View of the 1960’s, and most recently the Fiscal Theory of the Price Level.

The error that runs through all these debates is a failure to see that the value of gold, like all commodities, is determined by supply and demand, while the values of government paper and bank notes, like all financial securities, are determined by backing. People who have made otherwise valid criticisms of the Bullionist or Quantity Theory view have invariably fallen into the trap of thinking that government paper is valued like gold, while bank notes are valued according to their backing. This puts them in the indefensible position of claiming that paper money issued by governments is inflationary, while paper money issued by banks is not. Once we understand that backing determines the value of both bank notes and government paper, it becomes clear that the value of government paper is determined by the government’s assets, while the value of bank-created money is determined by the issuing bank’s assets.


Dollarization in practice and in a textbook

by Kurt Schuler January 10th, 2014 1:15 am

This week marks the 14th anniversary of dollarization in Ecuador. Unlike many other South American countries, Ecuador had experienced bouts of annual inflation in mid double digits but never a hyperinflation. In 1999-early 2000, a confluence of events that included a low world price for oil (Ecuador's main export), a fragile banking system distrusted by the public, a fractious political system, and a central bank that seemed unaware that its policies were at the root of inflation brought the country to the brink of hyperinflation. Ecuador's president then announced one evening that the country would replace its own currency with the U.S. dollar, and within a week signs of stabilization began to appear. Normally a 14th anniversary would not be especially noteworthy, but by my calculations, dollarization has now outlasted for durability any monetary arrangement that Ecuador has had since the 19th century. No rigid exchange rate and no variant of floating in the 20th century lasted as long.

Perhaps on the 15th anniversary I will say something of my involvement with suggesting dollarization in Ecuador some months before it came to pass, and of two Ecuadorians, Joyce de Ginatta and Dora de Ampuero, who mobilized substantial elements of the populace and the intellectuals, respectively, to make dollarization conceivable as a policy. For now, I will simply point out that among the naysayers about dollarization was Paul Krugman, who compared it to witchcraft, and move on to contrast dollarization in practice with dollarization in a textbook. The textbook is Carlos Végh's Open Economy Macroeconomics in Developing Countries. intended to be a graduate level textbook. An acquaintance kindly pointed out the book to me several months ago and showed me the long chapter on dollarization. I was astounded. There is page after page of equations, and nothing that I would ever use to talk to a president, prime minister, finance minister, or central bank governor (I have talked to some), let alone the man on the street. There isn't even anything I would ever use to talk to a Ph.D. economist if the focus was on possibly implementing it. A student reading the book would, I think, be ill equipped and maybe even unable to answer the fairly simple, practical questions that people want to know outside of a graduate school classroom.

Ecuador's last period of comparable durability to dollarization took place,  no surprise, under free banking. Ecuador's experience with free banking has not to my knowledge been summarized in English in an accessible article comparable to the one I cited a couple of posts ago on Peru. Material I have seen in Spanish considers free banking, but merely as one episode of Ecuador's longer monetary history, and the material is so old that it does not take account of the ideas about free banking pioneered by Larry White and George Selgin within the last 30 years. If there is writing that meets these criteria, though, please mention it in the comments.


Lehrman on gold

by Kurt Schuler January 5th, 2014 10:47 pm

Tyler Cowen's recent post on the resource costs of gold prompts me to write about two books on gold by Lewis Lehrman, which I have been meaning to do for some months. (See George Selgin's remarks in the comments section of Cowen's post. Also relevant is W. H. Hutt's idea decades ago in his book The Theory of Idle Resources. Apparently idle resources very often perform a function simply by waiting in readiness, as a book on your shelf does even if you have not read it yet, or even if you never read it.)

Lehrman has been a longtime advocate of the gold standard and has used his considerable wealth to help make the case through an institute that bears his name. The two books in question are The True Gold Standard (2nd edition, 2012) and Money, Gold, and History (2013). The former is a single sustained argument supplemented by a number of appendices, while the latter is a collection of old writings with some new material mixed in, arranged so as to show facets of the running argument for the gold standard that Lehrman has made for many years. The books are aimed at a broad general audience and should be read and understood in that spirit, not as if they are academic writings aimed primarily at influencing the half-dozen most highly regarded specialists in the field--although Lehrman obviously would not mind reaching them, too.

The basic argument of the two books is that (1) the Bretton Woods version of the gold standard had flaws, but (2) abandoning it was a bad mistake because what came afterwards was even more flawed, so (3) it is desirable to return not to the Bretton Woods version of the gold standard but to the more robust classical gold standard, and (4) it is feasible for the United States to do so alone or with other countries, according to (5) a proposed course of action that Lehrman offers.

If you have read a number of my posts you probably already have a sense of what I am going to say, so I will be brief.

Virtues: The books are clearly written and well suited for their intended audience. The distinction between the classical gold standard, in which the major economies all relied on their own gold stocks for reserves, and the interwar and Bretton Woods systems, which were gold exchange standards, is crucial, and Lehrman stresses it. A gold exchange standard is more fragile than a gold standard in the sense that if the gold-standard country one is linked to abandons gold or devalues, a gold exchange standard country faces more pressure to do likewise than it does if it hold its own gold reserves, which have retained value. Lehrman reviews how gold did not impede some of the most vigorous growth the U.S. economy ever had, in the 19th century. He answers a lot of the questions people would have about the specifics of returning to a gold standard. In The True Gold Standard, he offers a nod to free banking as an eventual possibility (page 104). He also repeatedly stresses that the analysis is a question of comparing realistic, historically tested systems, and choosing a "least imperfect" system, not pretending that either a gold standard or fiat money is a perfect system.

Shortcomings, from my perspective: Lehrman criticizes the gold exchange standard and proposes to eliminate it by international agreement, but I don't see it happening under central banking. The gold exchange standard in the form that Lehrman (and I) think is fragile arose because some central banks wanted to earn greater returns on their assets by substituting foreign interest-earning assets for gold. They accepted greater returns in exchange for greater risk to their assets. The same tradeoff would exist in a restored international gold standard.

Second, you know my view that a durable gold standard is not compatible with modern central banking. Modern central banks exist to practice discretion in monetary policy. Some have inflation targets as guidelines, but not as strict rules that they must always adhere to.  A strict gold standard of the kind Lehrman advocates conflicts with the spirit and practice of modern central banking. Under the classical gold standard, half the world did not have central banking, and in the half that did, the central banks were often privately owned, giving them greater autonomy from the state than later, government-owned central banks have typically had. I think that only a free banking system or possibly a currency board system will produce a durable gold standard under today's conditions of political economy.

Lehrman's proposal is specific to the United States. If a much smaller economy were to adopt a gold standard alone, it would not be sufficient to convert gold from its present role of predominantly a speculative commodity to the more mundane role of a unit of account with much smaller variations in purchasing power. But where might the tipping point be in terms of GDP of gold standard countries as a share of global GDP (if that is a good measure to use)? I would like to see Lehrman or somebody in his circle address the issue, even if the answer is necessarily imprecise.

So, as I wrote in an earlier post, let's have the debate on gold. We know that gold has flaws. After the global financial turmoil and then outright crisis of 2007-09, though, it is astounding to me that many of the people who are highly critical of a gold standard act as if the crisis had nothing to do with monetary policy and that the case for fiat money is as strong as it looked in the placid half-decade before the crisis.


New year, new reading

by Kurt Schuler January 2nd, 2014 10:11 pm

Free banking in Peru

Free banking in the United States (see here, go to bottom of page and click "load all," and search for "free banking")

The Fed versus the classical economists on the lender of last resort (ditto; search for "Thomas Humphrey")

The last two are from the upcoming American Economic Association meetings this weekend, which also features the most turgid title I have ever seen in an economics paper: "The Commodified Womb, Neoliberalism and the White Heteronormative Family."

ADDENDUM: Vern McKinley in Forbes on too big to fail. (Come on, contributors: when you write something relevant, mention it yourselves rather than letting me discover it and mention it belatedly for you.)